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By HaleStewart December 13, 2017 2:34 pm
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US Bond Market Week in Review: The Fed Is Chasing An Inflation Ghost

            The Fed voted to raise rates an additional 25 basis points.  After noting the economy was growing solidly, the observed:

Consequently, the Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will remain strong. Inflation on a 12‑month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee's 2 percent objective over the medium term.

There is little quibble about the labor market.  Unemployment is slightly about 4%, the employment/population ratio is increasing, and establishment job gains are strong.  The problem remains prices.  In the latest Minutes, it appeared the Fed was shifting away from its bullish outlook on inflation.  They acknowledged that underlying inflation would remain weak for the foreseeable future and even discussed various reasons for weak prices.  Now, it looks as though the Fed has returned to a harder view of the economy, believing that recent price weakness is temporary. 

If this analysis is correct, it’s unfortunate.  Today, the BLS released the latest CPI data, which, once again, was weak.  Three charts illustrate the situation:

On the left is total CPI, which has been slightly above 2% for the latter half of 2017.  But core (on the right) dropped sharply at the beginning of 2017.  Fed officials prefer this measure because it shows the impact (or lack thereof) of transitory factors like food and energy prices.  What’s especially telling is that in 2017 core dropped while overall rose. 

We can break CPI data down into four sub-components. 

Food and beverage prices (right; 13.62%) are weak.  They declined for most of 2016 and briefly contracted at the end of last year.  They have been rising for 2017, but are below 1.5% Y/Y.   Energy prices are increasing strongly, but they only account for 7.38% of CPI. 

All commodities less food and energy (left chart; 18.77% of CPI) has been contracting since 2014.  Services less energy (right chart, 60.21% of CPI) are increasing at a 3.32% rate.  But the weakness in other prices is deflating this total.

            And looking at PCE price measures, we see similar weakness:

The top chart shows total PCE prices, which are just below 2%.  But the 6-month average (orange) is declining and the 12-month average (in gray) is moving sideways.  The bottom chart shows the 3, 6, and 12-month average of core PCE’s prices; all are declining.

            Inflation is not a problem and there is no reason to believe it will accelerate in the near or even intermediate term.  The Fed is chasing a ghost.

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